Thoughts on Investment Process Summed Up

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One of the most common questions I get from readers as well as clients involves my overall investment philosophy. I talk about this often with clients, but I thought I’d write some comments specifically pertaining to my own investment philosophy and a few aspects of my approach that I think are of central importance.

Below are some points that help describe my investment philosophy.

Strategy

My firm has a simple investment objective: to compound our capital at high rates over the long term with minimal risk of permanent capital loss.

Our investment strategy is to make meaningful investments in high quality, predictable businesses that can be expected to compound value at high rates, and that are currently available at good prices.

One benefit to investing in undervalued high quality compounders is that investment returns can come from two possible sources:

  • The internal returns that the business generates
  • The possible increasing valuation level that the market “assigns” to the business

My approach involves one of Ben Graham’s fundamentals—thinking of stocks as entire businesses. This helps me to think more like a long-term business owner who focuses on things impact the business model and not about things that impact the near term stock price.

Although each investment has unique elements, these are a few of the attributes I am looking for as an owner-minded investor:

  • Simple, predictable business models
  • Track record of consistent profitability (high returns on capital and consistent free cash flow)
  • Favorable long term prospects for retaining and reinvesting earnings (compounding machine)
  • Shareholder friendly management
  • Significant value (cheap price)

This is a well-known gameplan, but one that is not often executed well. Below are some investment tenets that help me implement my strategy.

Margin of Safety

My investment philosophy is founded on Ben Graham’s famous “margin of safety” concept, which I define as the gap between price and value. I am focused on limiting the risk of permanent capital loss, and my objective is to limit unforced errors. To do this, I look for investment ideas that I can understand, and that are clearly and significantly undervalued. I define value as my conservative estimate of either:

  • The rate that I expect the investment to compound during my holding period, or
  • The price that a private buyer would pay for the entire business.

The margin of safety is the most important concept in my philosophy, and it is one that is talked about frequently, but still underrated and misinterpreted by most market participants.

It is very important—if not somewhat obvious—to understand that I am only interested in making investments in ideas that represent large and obvious gaps between price and value. In my opinion, a larger margin of safety both reduces risk and increases future returns—which is opposite of most investment theories which preach that with lower risk comes lower returns.

So my investment approach involves patiently waiting for these significantly undervalued investment opportunities. Too many investors are in a hurry to fill their portfolio with moderately undervalued ideas in an effort to either over-diversify or get fully invested—a practice which significantly dilutes returns over time. I am not excited about a stock that trades at $25 that has “30% upside”, to use a general example that represents what I often see in the blogosphere and on investment websites. Stocks that trade at $30 that are worth an estimated $40 simply do not have enough potential return to compensate for the inevitable uncertainty that exists with each situation. More importantly—the margin of safety (by my definition—the $10 gap between price and estimated value) is too slim—one minor mistake in analysis or one adverse development in the business can cause the investment principal to become impaired.

In fact, I’m less interested in assigning static values to investments, and more interested in thinking in terms of compounding. In other words, if I buy at the current price, what will my returns look like over my holding period as the business builds value and the valuation finds a normal level? Each investment is different, and some investments are bought with the intention to sell at a certain price, but my ideal investment is a compounding machine that builds value over long periods of time.

Think Like a Business Owner

I also find it helpful to think as a business owner would, not as a stockholder. I imagine myself buying 100% of each business, and I think of each investment as if it were the family business. If I’m not willing to buy the entire business, then I’m not interested in owning the stock. This approach—although often stated—is rarely actually implemented. To truly adopt this mindset gets one thinking in longer and broader terms—less about quarterly results, P/E ratios, and current earnings, and more about the business model itself—including the long term competitive position of the business, its durability, and its long term prospects.

I find that thinking like a business owner also goes along well with the margin of safety concept, as it steers me toward higher quality companies that on balance tend to build value over time and thus increase my margin of safety as time goes on. Thinking in this manner also helps me maintain a patient, disciplined, long-term approach, which I think is a productive mindset to have when investing in the stock market—and it’s a mindset that the majority of market participants lack, thus giving our partnership an important edge.

Make Meaningful Investments

My preference for investing in easily understandable investments with large gaps between price and value along with my business owner mindset leads me to a portfolio management style that is focused. Great investment ideas are simply not available every day, and my investment approach involves waiting patiently and remaining disciplined when good ideas are not available. This leads to both infrequent investment activity and a relatively small number of investments in the portfolio—both of which I feel reduce risk and increase the probability of achieving superior returns over time.

Most mutual funds and even the majority of value oriented funds own in excess of 30-50 positions (some funds own well over 100 stocks). This makes it virtually impossible to achieve significant outperformance. It also makes for much greater maintenance involved with following so many ideas, which I find difficult. The math of portfolio management is very compelling, and worthy of an entire post itself. A variety of research states that a 10-15 stock portfolio diversifies away the vast majority of so-called “market risk”—which is not something I’m concerned about anyhow. My goal is to reduce the risk of permanent capital loss, not worry about short term price fluctuations.

I tend to feel very comfortable making meaningful investments in a select number of great businesses, and I think it is far less risky to own a relatively small number of undervalued stocks that are well-researched than it is to own a large number of stocks that are comparatively less undervalued and less understood.

To Sum It Up

Our partnership believes that a conservative, disciplined, patient approach to buying significantly undervalued stocks of high quality companies that are growing shareholder value is the best way to achieve our goal of compounding our capital at high rates over the long-term with minimal risk.

I have a few more posts coming that will go into some more detail on these compounding machines that we all desire to own—specifically some more comments on the importance of reinvestment potential and return on invested capital, and how that pertains to value—which is in the end, what we are all after.

Via: basehitinvesting

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